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Estimating Future Returns: New Update

By guest contributors Adam Butler and Mike Philbrick
May 10, 2011

Note from dshort: Adam Butler and Mike Philbrick are Directors, Wealth Management and Portfolio Managers with Butler|Philbrick & Associates at Richardson GMP in Toronto, Canada. We have recently corresponded on the topic of historical market valuation. In the post below from their blog, they have used historic values to estimate future returns. Please visit their website GestaltU. At Butler|Philbrick & Associates, we don’t take anything on faith. Nor do we take expert opinions to heart, as we have shown time and again that experts make poor oracles. Instead, we believe in crunching the numbers ourselves to discover meaningful relationships in data. Where meaningful relationships exist, we apply statistical models to improve our chances of success.

Traditional Advisors assume that the best estimate of future market returns in all market environments is the simple long-term average return on stocks: about 6.5% per year after inflation. We hypothesized that it is possible to construct a statistical model using long-term market data which will allow us to make much more accurate predictions about long-term returns. It turns out that we were right. Those who are interested in the process we used, and the specifications of our model, are encouraged to read our full report.

There are several reasons why it may be useful to have a more robust estimate of future expected returns on stocks:

  • People who are approaching retirement need to estimate probable returns in order to budget how much they need to save.
  • A retiree’s level of sustainable income is largely dictated by expected returns over the early years of retirement.
  • Investors of all types must make an informed decision about how best to allocate their capital among various investment opportunities.

Many investors do not know that traditional wealth advice presumes that the best estimate of future stock market returns is always the average long-term return to stocks: 6.5% after inflation. No matter where markets are on the continuum from very cheap to very expensive, traditional Advisors will make recommendations on the assumption that investors should expect this same return on stocks over all investment horizons, as this is the average return to stocks, after inflation, since 1871.

To illustrate, imagine that a newly minted retiree visited a traditional Investment Advisor at the peak of the technology bubble in early 2000, when markets were more expensive than at any other time in the past 130 years. Despite the nosebleed valuations on stocks at the time, the Advisor, believing the typical rubbish about long-term stock returns, predictably asserts that the retiree should expect returns on his stock portfolio of 6.5% per year over his or her investment horizon, citing very-long-term average return statistics.

On the other hand our models, which account for the stratospheric valuation of stocks at the time, would have forecast inflation-adjusted returns to this client’s portfolio of negative 2% per year over the subsequent 15 years, a difference in returns of 8.5% per year versus the long-term average cited by the traditional Advisor above. In fact, this investor actually would have experienced returns of negative 1.55% per year through December 31, 2010, and would need a return of almost 22% per year through 2015 to realize the traditional Advisor’s year 2000 projections based on his 6.5% annualized estimate.

Table 1. applies this same analysis to other important periods over the past 100 years. We contrasted the return forecasts from a traditional long-term average approach with the forecasts from our valuation-based model, at a variety of transitional dates in stock markets, to demonstrate the improved accuracy of our valuation-based approach.

Posted Image Source: Shiller (2011), DShort.com (2011), Butler|Philbrick & Associates

You can see that forecasts derived from long-term average returns yield over 350% more error than estimations from our valuation-based model over these 15-year forecast horizons (1.35% annualized return error from our model versus 4.79% using the long-term average). Clearly our model offers substantially more insight into future return expectations than simple long-term averages, especially near valuation extremes.

Chart 1. shows how closely our valuation-based model has forecasted actual market returns over rolling future 15-year periods. The blue series is our model forecast, and the red series tracks actual market returns. The dotted line near the middle of the chart reflects a traditional 6.5% expected annualized return.

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Click for a larger image

So what does our model suggest about current market valuations and future expected returns? You can see from the chart’s blue line that expected returns from current levels are well below average. Even at the market’s lows in March of 2009, expected returns to stocks over the subsequent 15 years were only average, suggesting that markets simply achieved long-term average valuations at the market’s low. We were, and are, a far cry from the generational low valuations achieved around 1920, 1950, and 1980. If history is any guide, we may achieve those generational-low valuations mdash; which represent once-in-a-lifetime opportunities to buy stocks mdash; at some point in the next 5 to 10 years. Of course, we must endure another period of very low returns to achieve such low valuations.

So what level of annualized returns should we expect from stocks, after adjusting for inflation, over the next 5, 10, 15 and 20 years based on current valuations? Table 2. summarizes our model’s forecasts over these horizons. Only time will tell how accurate they might be, but history clearly proves that future returns from current valuations will be much closer to the forecasts below than to the long-term average of 6.5%.

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Source: Shiller (2011), DShort.com (2011), Butler|Philbrick & Associates

The investment industry has a large vested interest in convincing you that the same approach that delivered poor returns over the prior decade will deliver much more robust results over the next few years. That way, you will be convinced to hold your money in the same traditional, high margin products that made banks so much money, and lost investors so much money, over the last 10 years.

In periods of low returns, investors must have the courage to adopt a different approach if they hope to achieve better-than-average results. Our Gestalt Architecture was engineered to deliver strong returns in all markets, including markets which drop in value over several years or months. How does your Advisor plan to deliver robust results in the likely event that future returns are well below average?

View the original article on dhsort.com

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